Before we identify investment disaster recovery ideas, perhaps we should consider the different types of disaster that might confront an investor.
Black Swans, as described by Nassim Nicholas Taleb in The Black Swan (Random House, 2007), are truly unexpected, even unimagined, events that afterward seem entirely predictable (note that after a terrorist attack, everyone knows exactly how it could have been foreseen and stopped). For investors, the Black Swan effect may be best described by the title of Taleb’s prior book, Fooled by Randomness (Random House, 2004). By building ever more elaborate models and convincing ourselves we can plan for the unexpected, we fail to plan for the truly unexpected, which is, by definition, unexpected.
We also undermine our ability to plan for disasters we should expect. Truly, we cannot call the housing bubble’s bursting a black swan, because those who proclaimed that housing prices would go up forever were either delusional or disingenuous. Booms and busts are not black swans. What are they?
We’d like to add another couple of bird metaphors to the analysis of disaster predictability. Capistrano Swallows are events that really are predictable, except for the precise timing and scope. Booms and busts, market corrections, disruptive technology, and natural disasters fall into this category. For example, we know California will experience another big earthquake, but we don’t know when or where or how severe the damage will be. JP Morgan CEO Jamie Dimon testified to the Financial Crisis Inquiry Commission that he told his daughter financial crises occur every five to seven years. She asked, “Then why is everybody so surprised?” Good question. Although Dimon’s company weathered the latest disaster better than most, even he did not escape unscathed. He told the commission, “We didn’t do a stress test where housing prices fell.” Housing prices tripled in some areas between 2000 and 2006, and to be surprised by the market correction is like being surprised that the swallows return to San Juan Capistrano.
To us, rising oil prices and higher interest rates fall into the category of Capistrano Swallows, because the whole world is trying to revive the global economy, which still runs largely on oil. Eventually, disruptive technologies will compete with oil, but for the foreseeable future, growing economies will demand more energy, and greater demand leads to higher prices. Interest rates, in the meantime, are hovering near zero. Does anyone really believe they can stay there?
Chicken Pot Pies are events that may or may not happen, depending on a complex web of the actions of others. Consider the sovereign debt crises playing out in Europe right now. How would default by Portugal, Ireland, or Greece affect world economics and your portfolio? If Germany bails them out, does that reduce risk, increase it, or simply delay it? Inflation, deflation, stagflation, and other by-products of economic/government activity fall into this category because they are not inevitable, but if the right ingredients come together, we can expect hearty servings.
When one considers all the potential disasters that could befall an investor, from meteor strikes to earthquakes to government defaults to energy embargos to hyperinflation, we think the best disaster recovery plan is a disaster mitigation plan: focus on liquidity, keep debt to a minimum, and stay informed about your investments and their connections to broader social and political influences.
We’ll look at the disaster mitigation potential of liquidity, cash, and knowledge in Part 3: Don’t Believe Everything You Think.